Do capital constraints in fixed income markets demand a return to an agency approach by banks or is a more fundamental shift in market dynamics on the cards?
Basel III makes it harder for banks to provide liquidity in fixed income markets such as corporate and government bonds, leaving the buy-side holding much more of all the notional outstanding. So the priority should be to connect buy-side bondholders more effectively, right?
That sounds like a sensible place to start, but is it enough and could connecting the buy-side have unintended consequences that could further shrink sell-side market making capacity?
A recent report from consultants GreySpark Partners estimates that 96-99% of the US$250 billion of corporate bonds held by banks in 2007 is now held by the buy-side. If this buy-side liquidity can be mobilised and made available to the global investment community in a cost-effective fashion, then the declining market making and risk transfer capacity of the sell-side may be of less consequence.
Whether operating liquidity pools or aggregating them – or otherwise facilitating the exchange of information about supply and demand – the sell-side could be seen as reverting to the mean in this evolving new era. A couple of decades ago, most banks performed an agency role in bond markets, but competition for market share led to greater use of their balance sheets to facilitate secondary market activity. That was fine in the boom days, but today’s restrictions on capital demand a change of approach.
Different times need different models. So is it just a matter of managing a transition without causing too much disruption to market participants?
Perhaps, but many uncertainties and practical difficulties stem from the pendulum swinging too far in the opposite direction, leading us into uncharted territory. Even when brokerage has been more about agency than principal trading, the sell-side has funded a lot of the platforms, technologies and services that have supported liquidity provision. Obviously this was not done for altruistic purposes alone, but severely reduced revenue sources for brokers in the emerging environment could lead not only to a tailing off of these services but a more fundamental shift of roles. In the modern financial era, a key role for banks is the warehousing of risk for other financial institutions for decades. Both banks are their clients are nervous about a shift away from this role. Should asset managers make prices, trade, clear, and settle transactions, develop their own platforms? There are plenty of examples of each in the past and the present if you look hard enough, but is it what asset managers’ clients, shareholders and indeed regulators want them to be doing, when there is already an industry established for this purpose?
What practical problems might accompany this paradigm shift?
Markets have always needed a large array of different actors with different motives to work effectively. In times of volatility and / or low liquidity, you need someone willing to make a bet in the opposite direction. Diverse as the buy-side is, this may simply not be possible when every nervous investor is heading for the exits. Banks are not the only liquidity providers in the market but they certainly are among the most important – there aren’t many high-frequency trading firms providing liquidity in the fixed income markets.
And if the buy-side achieves a perfect view of the market based on connecting to multiple liquidity pools or sharing inventory details with peers in real time, what happens when they still can’t find the other side? What kind of pricing can they expect from brokers for taking on positions their buy-side clients can’t shift themselves?
Clearly different times do require different models. But we should think twice before allowing them to redefine the fundamentals of how a market works.